Year-End Gifts at All-Time Low Price! Shop Now to Avoid the Holiday Rush!

For estate planning attorneys, T.S. Eliot had it all wrong. April isn’t the cruelest month; it’s December. [1] No time for Christmas caroling. No wassail punch. Just Ebenezer Scrooge, ordering his staff to work the week between Christmas and New Year’s Day, scrambling to help clients make year-end gifts. And this year-end promises to be even busier than usual because of the expiration of the $5.12 million gift-tax exemption when the big ball drops at Times Square. This is oneyear you want your clients to start their gift-shopping early.

I. “Behold, I bring you good tidings of a great gift tax exemption … for 2012 only.”

At the end of 2010 (the year of no estate tax), President Obama signed a law that set into motion several key elements affecting the federal estate and gift tax:[2]

The estate and gift taxes were unified — the same exemption amounts apply to both taxes, establishing a “you may use the full exemption during life or at death” opportunity.[3]

In 2011, the exemption was $5 million per person and it increased to $5.12 million per person in 2012.[4] Transfers exceeding the exemption were taxed at a 35 percent rate.[5]

For married couples, filing a federal 706 estate tax return upon the death of the first-to-die spouse in 2011 or 2012 preserved the unused exemption of the deceased-spouse for the surviving spouse (this is called “portability”).[6]

This all-time-high gift tax exemption “sunsets,” that is, it goes away, at the end of 2012, at which point the law that applied prior to 2002 returns with a vengeance: the exemption decreases from $5.12 million to $1 million, transfers exceeding the $1 million exemption are taxed at a graduated tax rate that tops out at 55 percent, and portability vanishes.[7]

This means that on Jan. 1, 2013, folks will lose $4.12 million of transfer-tax exemption that they had the day before. In terms of real cost, a person who dies with $5.12 million of assets on Dec. 31, 2012, would pay no federal estate tax, while that same person, by dying one day later, would pay more than $2 million in federal estate tax. All of this creates a great opportunity to spend the remaining shopping days of 2012 taking advantage of high exemption amounts before they expire on Jan. 1.

II. “… Which will be to all people, even Tennesseans.”

This unprecedented opportunity to give $5 million away free of federal gift tax has been with us since Jan. 1, 2011, but the Tennessee gift tax had to be reckoned with. A $5 million gift in 2011 resulted in a Tennessee gift tax of $463,400. Many Tennesseans want to give illiquid assets such as farm property or interests in family businesses. Clients often didn’t have the hundreds of thousands of dollars to pay the Tennessee gift tax, or were understandably reluctant to take a sizable bite out of their cash reserves. The Tennessee gift tax was a real-world deterrent to making the big gift and taking advantage of the federal exemption.

Thanks to Tennessee’s legislature, this past May Tennessee eliminated its gift tax retroactive to Jan. 1, 2012.[8] No longer do we have to counsel our clients regarding the Class A/Class B beneficiary structure (if you don’t know what we’re talking about, consider yourself lucky!). No longer do we have to counsel our clients that a Tennessee gift tax will be exacted upon a big gift.

Our General Assembly also passed a law phasing out the Tennessee inheritance tax in the same legislative session.[9] We’ve encountered many clients over the summer who confused the gift tax legislation with the inheritance tax legislation, and mistakenly believed that the gift tax is subject to a gradual phase-out. This is incorrect — the Tennessee gift tax has already been laid to rest, and the funeral service for the Tennessee inheritance tax has been scheduled for midnight on Dec. 31, 2015.

III. “Glory in the highest!” The 2012 gifting opportunity.

The combination of the two factors discussed above — $4.12 million of expiring exemption and the elimination of Tennessee’s gift tax — means that there is an opportunity during the remaining days of 2012 for a client to gift $5.12 million ($10.24 million for married couples), incur no federal or Tennessee tax, and reduce the value of their federal taxable estate by the amount of the gift plus whatever appreciation is earned on the gift during the client’s lifetime.[10] This is a fantastic opportunity for high net worth clients. The estate and gift tax is on sale at record prices, and the sale ends Dec. 31.

IV. “Good will toward all men and women in your bloodline.” Make the big gift to a dynasty trust.

So, you have sold your clients on making a big gift and they’re excited that they won’t have to pay any Tennessee gift tax, now what? Whatever you do, counsel them to resist the urge to write a $10.24 million check to Junior. It will be spent by the time the SEC champ wins the BCS championship game. Encourage your clients … insist that your clients leave it to Junior in trust. Junior will be disappointed initially, but he’ll thank you later.

There are lots of types of trusts that would work as a vehicle for a major 2012 gift. Here, we’ll focus on the advantages of using a traditional dynasty trust.

You can allocate your generation-skipping transfer tax exemption (also $5.12 million per person and $10.24 million per married couple in 2012) to the trust, so the big gift can remain in trust for the Tennessee Rule Against Perpetuities period — 360 years.[11] The assets in the trust, and distributions from the trust to children, grandchildren and subsequent generations, will be exempt from federal estate, generation-skipping and gift taxes, Tennessee gift taxes — and if your client lives until 2016, from Tennessee inheritance taxes, for 360 years;

The assets inside the trust will be protected from the creditors and predators (including future ex-spouses) of the trust beneficiaries; and

The assets in the trust can stay in the family bloodline, continuing in trust from generation to generation for the 360-year perpetuities period. It’s folly to believe we can anticipate all future outcomes and circumstances affecting our descendants. The well-drafted Dynasty Trust addresses this issue by giving limited powers of appointment to each generation.

If Junior is responsible enough he can serve as his own trustee of the Dynasty Trust so long as his right to withdraw income and principal for himself (and his descendants) is governed by certain IRS-sanctioned safe harbor criteria. For example, Junior can have the right to serve as his own Trustee if trust distributions to Junior and his family are limited to health, education, maintenance and support.

Other traditional options for choice of Trustee can also be utilized: bank trust departments; independent trust companies; family members; friends; business associates; CPA’s and attorneys. Since the Dynasty Trust is going to last for an unprecedented period of time, flexibility is built into the trust document allowing for selection of successor trustees by beneficiaries, family councils, acting trustees, trust protectors or trust advisory committees.

V. “What if I need the money?” The spousal access trust.

The biggest resistance (and most obvious objection) to making a big gift is clients’ understandable concerns of losing access to a significant portion of their assets. The rising costs of health care, uncertainty in the financial markets and other factors make clients leery of making big gifts for fear that they will not have sufficient assets left for their own needs. When this “what if I run out of money and need the assets back?” concern is raised, you often realize that a client is not a great candidate for a big gift. After all, we don’t want to do something for tax reasons that might actually restrict our clients’ qualities of life or financial certainty. Resist making any assurances to your clients that Junior will take care of them!

But for clients who are married, there is a partial solution: Husband creates a trust with up to $5.12 million for the benefit of Wife (“Husband’s Trust for Wife”) and Wife creates a trust with up to $5.12 million for the benefit of Husband (“Wife’s Trust for Husband”). Let’s look closer at Husband’s Trust for Wife for illustration: income and principal from the trust can be distributed to Wife, children and grandchildren for their health, education, maintenance and support; Wife can even be the trustee or co-trustee of the trust; and at Wife’s death the trust continues for the benefit of the children, grandchildren and beyond. And all of the same can be true for Wife’s Trust for Husband.

This two-trust structure means that while both spouses are living, all of the gifted assets are still available to the couple for their needs. The only beneficial use that each spouse is giving up is the right to access the assets of the deceased spouse’s trust once one spouse has died. For example, if Husband dies, at his death Wife’s Trust for Husband is now solely for the benefit of the children and grandchildren (since the primary beneficiary, Husband, is dead). Wife cannot be a beneficiary of this trust since she was the grantor. Therefore, for the rest of her lifetime, Wife will continue to have access to Husband’s Trust for Wife but she will not have access to the assets in Wife’s Trust for Husband. Bottom line, with this two-trust approach the married couple has access to all the gifted assets while both are living and the surviving spouse has access to one, but not both, of the trusts after one spouse dies. The two-trust approach is a great way for married clients to make a gift and still keep the beneficial enjoyment of the assets inside the marriage so long as both spouses are alive.

It is important to mention that the reciprocal trust doctrine has to be considered before drawing up these two trusts for married clients. The reciprocal trust doctrine is a judicially created doctrine, not found in any statute or regulation, derived from the pesky truth that the IRS will look at substance over form. If Alice creates a trust for Betty, and Betty creates an identical trust for Alice, it looks like a pre-arranged transaction where Alice in substance ends up with a trust for herself and Betty with a trust for herself.

In the reciprocal trust doctrine’s hallmark case, U.S. v. Estate of Grace, Husband and Wife created mirror image trusts — Wife created a trust for Husband and Husband created a trust for Wife.[12] In siding with the IRS, the Court in Grace brought the assets of Wife’s trust (which had been created by Husband) back into Husband’s estate on the premise that the mirror image trusts were sham form-over-substance devices. “[A]pplication of the reciprocal trust doctrine requires only that the trusts be interrelated, and that the arrangement, to the extent of mutual value, leaves the settlors in approximately the same economic position as they would have been in had they created trusts naming themselves as life beneficiaries.”[13]

The reciprocal trust doctrine has been explored in other circumstances. In PLR 9643013, the IRS said that the doctrine did not apply in a circumstance where Husband created a trust for Wife with Wife as trustee and the children (not Wife) as beneficiaries, and Wife created a trust for Husband with Husband as trustee and Husband and the children as beneficiaries.[14] Ultimately, the doctrine is a bit murky, and we, as attorneys, should think about incorporating some of the ideas mentioned below in efforts to avoid creating reciprocal trusts:

Don’t create the trusts at the same time. The more time between the creation and funding of each trust the better. If the current gift and estate tax scheme expires at the end of 2012 (as it is set to do) and doesn’t get extended, you’ll most likely be creating these trusts in close succession to each other, so make sure you think hard about incorporating several of the other ideas mentioned below.

Change up the trustees. Make the beneficiary spouse the trustee of one trust and name a relative, child or corporate entity as the trustee of the other trust.

Give one spouse a special power of appointment in his or her trust. In one of the trusts, give the spouse the power during his or her lifetime to direct where the trust assets go at such spouse’s death. Don’t include a power of appointment in both trusts.

Change up the beneficiaries. Maybe if the couple doesn’t really feel like they’ll need all the assets gifted to the trusts, pick the spouse with the best life expectancy and make him or her a beneficiary (along with the kids and grandkids) of one trust and leave the other spouse out as a beneficiary of the second trust (i.e., Husband’s Trust for Wife is for the benefit of Wife, kids and grandkids while Wife’s Trust is only for the benefit of kids and grandkids, not Husband).

Only give one spouse a right to withdraw principal. Again, if you don’t anticipate that the couple will have a cash liquidity problem, choose the spouse with the best life expectancy and give him or her a right to withdraw principal (remember to always use an ascertainable standard) from their trust while the other spouse only has access to income during his or her lifetime.

Give one spouse a 5 percent withdrawal right in the trust each year. Again, we’re just thinking of ways to strengthen our argument that the trusts should not be uncrossed because the trusts are not mirror images.

There are many other ways to vary the trusts, and you should consider using as many ways as you can think of to make the economic realities of the trusts as diverse as possible while still giving your clients the access that they will need. If you are drawing up these trusts after you read this article (say on New Year’s Eve), it will be very important for the trusts to reflect several of these divergences since they will be created in close temporal succession.

VI. Other Ways to Use the 2012 Gift Tax Exemption.

If the client doesn’t want to give away millions to a dynasty trust or to a spousal access trust, there are other ways to take advantage of the 2012 gifting window.

Gift to an existing insurance trust (or ILIT). Gift enough cash, or income-producing property, to an existing life insurance trust so it will have assets to pay all future insurance premiums.[15] This would mean that you won’t have to worry about the Crummey letter regime each time a new premium payment is due! Instead of reinventing the wheel with a new trust, clients can make gifts to their existing insurance trusts.

Forgive loans. This is a good year to rip up the notes that your kids or other ne’er-do-well relatives owe to you and not trigger any gift tax consequence.

Help the kids buy a home. If you want to make sure that they don’t mortgage the home or sell it to squander away its proceeds or lose half of it to an ex-spouse in a divorce, your client could buy the home for their kids inside a trust. Making the home purchase inside a trust would also protect the home from any judgments from creditors and spousal claims in a divorce or at death.

Establish a QPRT.[16] Your clients can put their residences into trusts that specify that they will reside in the home for some number of years and then the residence will go to one or more children or to a trust for them. At the time of transfer your clients will be making a gift of a remainder interest and so long as that remainder interest is valued at less than $5.12 million, no gift taxes will be owed. Keep in mind the caveat when dealing with QPRT’s: if a client dies during the occupancy term, the entire value of the residence will be included in his or her gross estate. Also, if a client continues to live in the home beyond the occupancy term, he or she will need to pay rent.

VII. But, wait! Maybe you can give even more than $5.12 million!

There are several ways in which a $5.12 million gift can turn into a much larger gift. Any appreciation in the value of the gifted assets between the date of the gift and a client’s death means that more money has passed to the recipients of the gift — money that would have otherwise been in the client’s taxable estate.

If your clients are doing gifting through trusts, like the trusts that are discussed above, consider designing the trusts as intentionally defective grantor trusts (a “grantor trust”). You may design a grantor trust to keep the trust’s assets out of the grantor’s taxable estate while at the same time making the grantor responsible to pay the ongoing income taxes associated with the trust. Each time the grantor makes a payment of income taxes on behalf of the trust, the grantor is making an additional tax-free gift to the beneficiaries of the trust because money in the trust didn’t have to be spent to pay income taxes. The trust assets that would have been used to pay the income tax will stay in the trust and continue to grow.

You may also want to counsel your clients to make their gifts in ways that qualify for one or more valuation discounts. Before making a gift, contribute the assets into a multiple owner LLC, then gift LLC units to the trust that qualify for valuation discounts. Or divide the farm into two tenant-in-common interests and put each undivided one-half interest into its own trust — an undivided tenant-in-common interest qualifies for a valuation discount. These, along with many other ways, may reduce the value of gift.

VIII. “Unto you this day … a gift is born.”

2012 is a rare opportunity to make a really big gift — up to $5.12 million for individuals or $10.24 million for couples. If your clients have the means and you have the availability in your calendar, encourage your clients of substantial wealth to take advantage of 2012’s large gift exemption. On Jan. 1, 2013, your clients will have $4.12 million less of gift exemption than they had the day before. Now, get to shopping!

Notes

In T.S. Eliot’s The Waste Land, he writes, “April is the cruelest month.”

Since the Tennessee inheritance tax taxes gifts made within three years of death, there may be a clawback for Tennessee inheritance taxes if the client dies before 2016.

Tenn. Code Ann. § 66-1-202(f).

United States vs. Estate of Grace, 395 U.S. 316, 318-319 (1969).

Id. at 324.

PLR 9643013 (Oct. 25, 1996).

These trusts are designed to keep death payouts from insurance policies out of the insured’s taxable estate.

Qualified Personal Residence Trust.

HUNTER R. MOBLEY is an attorney at Howard Mobley Hayes & Gontarek PLLC, a boutique trusts and estates firm in the Green Hills community of Nashville. He concentrates his practice in the areas of estate planning, estate administration and charitable planning. In addition to estate planning for individuals and families, he advises foundations, churches and other nonprofits in connection with tax planning, tax disputes and organizational governance. Mobley received an LL.M. in taxation from New York University, a law degree from University of Kentucky and a bachelor’s from Davidson College.

JEFFREY MOBLEY is a co-founder of Howard Mobley Hayes & Gontarek PLLC, and concentrates his practice in the areas of estate planning, tax planning for estates and trusts, business succession planning, prenuptial and postnuptial agreements, estate administration, resolution of disputes involving estates and related real estate matters. A Fellow in the American College of Trust and Estate Counsel, he is a co-author of the frequently cited Pritchard on the Laws of Wills and Administration of Estates (7th ed. 2009). Mobley is an Order of the Coif graduate of the University of Kentucky College of Law.